Exclusive: Reynolds American, Lorillard in advanced merger talks

Danny Herko, senior vice president of Research and Development of R.J. Reynolds Tobacco Company, demonstrates the use of a VUSE Digital Vapor Cigarette at a news conference in New York in this file photo taken June 6, 2013.Zoran Milich/Files

NEW YORK (Reuters) - Reynolds American Inc RAI.N is in active discussions to buy Lorillard Inc LO.N in a complicated, three-way transaction that could see British American Tobacco PLC (BATS.L) take a major role to back a potential merger, according to people familiar with the matter.

The proposed deal, which is in late stage talks, would unite the second- and third-largest U.S. tobacco companies that have a combined market value of nearly $55 billion, putting brands such as Reynolds' Camel and Lorillard's Newport under one roof.

The companies are working to finalize an agreement in as soon as a matter of weeks but the talks will likely take longer given the complex structure, the people said, asking not to be named because the matter is not public.

Reynolds, in which British American Tobacco (BAT) has a 42 percent stake, has a market capitalization of $32 billion after its shares rose 4.4 percent Wednesday on news of the merger talks. Shares of Lorillard jumped more than 10 percent, giving it a market capitalization of $22.7 billion.

Because Reynolds plans to use its own stock to pay for part of the Lorillard deal, BAT's holding in Reynolds would decrease if the merger goes through.

One option is for BAT to help finance Reynolds' bid so it would keep its ownership in the combined company at current levels, one person said. BAT's involvement could also take different forms, another person added.

Reynolds, Lorillard and BAT are working with financial advisers on the proposed deal and talks have been underway for months, the people said, cautioning that there are many moving pieces and discussions could still fall apart.

A merger between Reynolds and Lorillard would create a formidable rival to Marlboro cigarette maker Altria Group Inc (MO.N), the market leader with a roughly 50 percent share of the U.S. tobacco industry.

Reynolds and Lorillard have a market share of 27 percent and 15 percent, respectively, and the proposed combination would face substantial antitrust issues.

The companies are hammering out details of potential divestitures in order to address regulatory concerns, according to the people familiar with the matter.

All the people asked not to be named because they were not authorized to speak with the media. Representatives for Reynolds and BAT declined to comment. Lorillard could not be immediately reached for comment.

Buying Lorillard would boost Reynolds' position in the fast-growing electronic cigarettes market at a time when U.S. tobacco companies are grappling with declining sales due to government regulation. Lorillard's blu product is the leading e-cigarette brand, with a U.S. market share of around 50 percent.

E-cigarettes are crucial to the three major U.S. tobacco companies, which have bought or developed their own brands in recent years. Sales of the electronic products in the U.S. are expected to outpace traditional cigarettes by 2020.

Reynolds has its own e-cigarette product called Vuse, which is currently sold in only two U.S. states, and is in the process of rolling out nationwide. Altria Group has the MarkTen brand and also is going nationwide.

But the possibility of a tie-up between Reynolds and Lorillard has raised some eyebrows from analysts, as the Food and Drug Administration has said it is considering restricting or banning menthol cigarettes, which make up the majority of Lorillard's sales.

The percentage of adult smokers in the United States fell to 19 percent in 2011 from 22.8 percent 10 years earlier, according to the Centers for Disease Control and Prevention.

Merger speculation involving tobacco companies has increased after the Financial Times said in March that Reynolds was exploring a bid for Lorillard. The Times of London separately reported this month BAT is exploring possible deals for either Reynolds or Lorillard.